An Introduction to Cryptocurrency and Blockchain
Cryptocurrency and Blockchain technology are gateways to the next era of digital finance and financial freedom. The way we think about currency and transactions is being revolutionised and digitised right before our eyes.
Crypto and Blockchain Essentials
The crucial elements of the digital finance space you ought to consider researching and educating yourself on before investing in cryptocurrencies and blockchain technology.
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1. Understanding Cryptocurrency
What is important to mention is that there is a fine distinction between cryptocurrency and blockchain. Cryptocurrency is digital money, whereas blockchain is a form of database.
1.1 What is Cryptocurrency?
Cryptocurrency is a digital or virtual form of money/currency that uses cryptography for security and operates independently of a central bank. It is decentralised and is often based on blockchain technology. Unlike traditional currencies, cryptocurrency exists only in a digital form and utilises a distributed ledger system known as a blockchain for secure and transparent transactions.
1.2 How Does Cryptocurrency Work?
Cryptocurrency transactions are recorded on a public ledger called a blockchain. When a transaction occurs, it is added to a "block" and then linked to the previous transaction, creating a chain of blocks. This decentralised system makes it virtually impossible to alter transaction histories, ensuring the security and integrity of the currency.
1.3 How Cryptocurrencies Are Created
Some cryptocurrencies are 'mined' whereas others are created through a 'hard fork'.
Minable Cryptocurrency
Mining is the term used to describe the process of creating certain cryptocurrencies. Transactions made with cryptocurrencies need to be validated, and mining performs the validation and creates new cryptocurrencies. Mining uses specialised hardware and software to add transactions to the blockchain. Minable coins are generally used on Proof-Of-Work blockchains.
Pros and Cons of Mineable Cryptocurrency
✓ Coins are generally considered more secure
✓ Maximises participation
✓ Equitable distribution
✖ Costly to secure the network
✖ Energy inefficient
✖ Vulnerable to centralisation
Non-Mineable Cryptocurrency
For non-mined cryptocurrencies, developed create new currency through a hard fork. A hard fork creates a new chain in the blockchain. One fork follows the new path, and the other follows the old one. Crypto you cannot mine is typically used for investments rather than purchases, but this is not always necessarily the case; there are non-minable coins that can be used for purchases. Non-minable coins are generally used on Proof-Of-Stake blockchains.
Pros and Cons of Non-Mineable Cryptocurrency
✓ Energy efficient
✓ Network is easy to secure
✓ Cheaper to acquire
✓ Mitigates centralisation risks
✖ Often initially limited distribution
✖ Potential Lack of Incentives
1.4 Cryptocurrency VS Traditional Currency
Governments produce traditional currency in paper bills and coins you can physically carry with you or put into the bank. You can use it for purchases and other transactions that require cash. A government backs traditional currency, while cryptocurrency has no government, bank, or financial institution control.
While you can hold traditional currency in a bank or a financial institution, you store cryptocurrencies in a digital wallet.
1.5 Advantages of Cryptocurrency
One of the biggest advantages of cryptocurrency versus traditional currency is privacy. When you purchase a cryptocurrency, or make a purchase using cryptocurrency, you do not necessarily need to provide any personal information or a form of identification. This protects you from potential identity theft and other fraudulent activities. And no matter what may happen to a government, your investment remains secure.
Moreover, cryptocurrency is worldwide, so there is no need to figure out or pay foreign exchange rates, although cryptocurrency is not considered legal in some countries. You also do not need to worry about bank account restrictions, such as ATM withdrawal limitations.
🔒 Enhanced Security and Privacy
A primary advantage of cryptocurrency is the enhanced security it offers. Traditional banking systems rely on centralised authorities, making them more susceptible to hacks and fraud. In contrast, cryptocurrencies use decentralised blockchain technology, ensuring that transactions are transparent and secure.
Moreover, cryptocurrency transactions can be executed pseudonymously, providing users with increased privacy. Unlike traditional banking systems where personal information is linked to financial transactions, cryptocurrencies allow for anonymous transfers, safeguarding user data.
🌐 Worldwide Accessibility and Elimination of Middlemen
Cryptocurrencies have no geographical boundaries, allowing anyone with an internet connection to access and participate in transactions. This global accessibility opens doors for financial inclusion, especially for the unbanked population worldwide. With cryptocurrencies, individuals in remote areas can easily store, send, and receive funds without the need for a physical bank.
Furthermore, cryptocurrencies eliminate the need for intermediaries such as banks or payment processors. This peer-to-peer system not only reduces transaction fees but also enables quicker and more efficient transactions. Without the involvement of middlemen, individuals can have more control over their financial activities.
💲 Lower Transaction Fees and Faster Transactions
When compared to traditional banking systems, cryptocurrency transactions generally involve lower fees. Traditional financial institutions often charge hefty fees for international transfers, conversions, or even basic account maintenance. Cryptocurrencies, on the other hand, have significantly lower transaction fees, making them a cost-effective option.
In addition to lower fees, cryptocurrency transactions are typically faster compared to traditional methods. Traditional bank transfers often take several days to complete, especially for international transactions. Cryptocurrency transactions, however, can be executed within minutes, irrespective of the sender and receiver's locations. This speed and efficiency contribute to the growing appeal of cryptocurrencies.
💸 Increased Financial Freedom and Control
Cryptocurrencies provide individuals with increased financial freedom and control over their assets. With traditional banking, accounts may be frozen or restricted based on various factors, leaving individuals unable to access their funds. Cryptocurrencies offer a decentralised system where individuals have sole control over their digital wallets, ensuring that their funds are always accessible.
Moreover, cryptocurrencies enable borderless payments and remittances, bypassing the need for exchange rates and restrictions. This financial sovereignty empowers individuals by giving them the ability to manage their finances without external interference.
💰 Investments and Profit Potential
Cryptocurrencies also offer significant opportunities for investments and profit potential. Many individuals have witnessed substantial returns on their investments in cryptocurrencies like Bitcoin and Ethereum. With careful research and analysis, individuals can take advantage of market volatility and make informed investment decisions.
Furthermore, cryptocurrencies allow for fractional ownership, enabling individuals to invest in assets that were previously inaccessible. Real estate, artwork, and even rare commodities can be tokenised, making them more accessible to a broader audience.
1.6 Types of Cryptocurrency
Cryptocurrency is available as coins or tokens. The difference between them is that tokens are assets that exist on a blockchain, while coins can be virtual, digital, or tangible. Coins are more like traditional money; a digital coin has its own blockchain. Conversely, a token is created on an existing blockchain and can be used as currency or to represent asset ownership.
The first cryptocurrency introduced was Bitcoin, the most commonly traded one. Ethereum is the second most valuable cryptocurrency and can be used for a variety of complex transactions. Other more common cryptocurrencies, known as altcoins, include Cardano, Solana, Chainlink, Avalanche, and XRP.
1.6.1 Cryptocurrency Catagories
🟠 Bitcoin: The Pioneer
Bitcoin, the first cryptocurrency introduced by the mysterious Satoshi Nakamoto in 2009, remains the most well-known and widely used digital currency. With a finite supply cap of 21 million coins, Bitcoin operates on a decentralised peer-to-peer network, allowing users to transact without the need for intermediaries.
Unlike traditional currencies, Bitcoin is not issued by any government or central authority, making it immune to government inteference and manipulation. Every transaction made with Bitcoin is recorded on the blockchain and is verified by a network of computers, known as miners. The decentralised nature of its network makes it resistant to fraud and censorship, as no single party can control or manipulate the entire network.
Bitcoin has gained significant popularity over the years, with a growing number of merchants and businesses accepting it as a form of payment. Its adoption has been driven by factors such as the low transaction fees compared to traditional banking systems, quick and borderless transactions, and the potential for investment and speculation. However, the volatility and lack of regulation in the bitcoin market pose risks to users and investors.
It is a revolutionary digital currency that operates outside the realm of traditional financial systems. Its key features, such as decentralisation, transparency, and security, have attracted a wide range of users and businesses. While Bitcoin offers numerous advantages, it also carries risks and challenges that need to be carefully assessed and managed for widespread adoption and acceptance.
🔵 Altcoins: Diversifying the Crypto Landscape
Altcoins, or alternative coins, refer to any cryptocurrency other than Bitcoin. These digital assets aim to address specific limitations of Bitcoin or offer unique features. Altcoins serve various purposes, from enhancing privacy in transactions to offering unique features such as smart contracts and decentralised applications. These digital assets contribute to the innovation and evolution of the blockchain industry.
As Bitcoin's dominance wavers, altcoins have gained traction, showcasing higher volatility and potential for significant returns. Investors are drawn to altcoins for their ability to diversify their portfolios and explore new investment opportunities. With thousands of altcoins available, choosing the right ones to invest in can be overwhelming. Researching the technology, team behind the project, market demand, and community support can help investors make informed decisions.
As the cryptocurrency market continues to evolve, altcoins are poised to play a significant role in shaping the digital economy. Staying informed, adopting a long-term perspective, and being open to new possibilities are key to embracing the potential of altcoins.
🟢 Stablecoins: Finding Stability in Volatility
Stablecoins are a subset of cryptocurrencies designed to minimise price volatility by pegging their value to a stable asset, such as fiat currency or commodities. This stability makes stablecoins ideal for everyday transactions and as a store of value in times of market turbulence.
Fiat-Backed Stablecoins
Fiat-backed stablecoins, as the name suggests, are backed by traditional fiat currencies like the US Dollar or the Euro. These stablecoins are usually issued by a central authority or a trusted financial institution that holds an equivalent amount of the fiat currency as collateral. The value of the stablecoin is directly tied to the value of the underlying fiat currency, providing stability and ease of use for those who are hesitant to fully embrace traditional cryptocurrencies.
Crypto-Backed Stablecoins
Crypto-backed stablecoins are backed by other cryptocurrencies. These stablecoins are issued by creating a reserve of other cryptocurrencies, such as Bitcoin or Ethereum, and using it as collateral. The value of these stablecoins is determined by the value of the underlying cryptocurrencies in the reserve. While this method provides decentralisation and security, it also exposes these stablecoins to the volatility and price fluctuations of the cryptocurrency market.
Algorithmic Stablecoins
Algorithmic stablecoins rely on complex algorithms and smart contracts to maintain their stability. These stablecoins do not have any collateral backing, but rather use a system of incentives and penalties to keep their value stable. For example, if the price of the stablecoin starts to rise, the algorithm will automatically increase the supply of stablecoins to bring the price back down. Conversely, if the price starts to drop, the algorithm will decrease the supply to stabilise the price. This type of stability mechanism can be seen in stablecoins like DAI, which is backed by the Ethereum blockchain.
🔴 Memecoins: Riding the Wave of Hype
Memecoins, characterised by their viral and often meme-driven nature, have gained prominence in the crypto space. While not always backed by strong fundamentals, memecoins like Dogecoin and Shiba Inu have captured the attention of investors seeking quick gains and a sense of community.
One of the key aspects of memecoins is their connection to popular memes and internet culture. Memes have become the language of the internet, transcending borders, cultures, and languages. Memecoins capitalise on this universal appeal by creating coins that have their value tied to specific memes or meme-related content. This connection not only adds a fun and humorous element to the digital currency market but also creates a sense of community and relatability among memecoin enthusiasts.
Their potential for investment and profit is quite remarkable. Althoigh memecoins often start as a joke or a parody cryptocurrency, some have gained significant value over time, attracting serious investors. The fluctuating nature of memecoins, combined with their connection to popular memes, can create opportunities for quick gains or losses. additionally, the scarcity of some memecoins adds to their value, as collectors and enthusiasts strive to obtain limited editions or items linked to a specific meme.
1.6.2 Cryptocurrency Tokens
💎 Value Tokens
These types of tokens are objects of value, such as digital assets like art or music in the form of an NFT (Non-Fungible Token). Their primary purpose is to serve as a store of value. They can be seen as digital gold, representing ownership and holding intrinsic value.
While a cryptocurrency such as Bitcoin could be considered a value token, the category is vast and diverse, with each token having its own characteristics and value proposition.
🎨 Non-Fungible Tokens (NFTs)
NFTs are unique digital assets verified using blockchain technology. Unlike cryptocurrencies such as Bitcoin or Ethereum, where each token is identical (or fungible), each NFT is distinct and cannot be exchanged on a one-to-one basis.
Characteristics:
Uniqueness: Each NFT has a distinct value and specific information that makes it different from other tokens. This uniqueness is verified and stored on the blockchain.
Indivisibility: NFTs cannot be divided into smaller units and sold.
Provenance: The blockchain verifies the authenticity and ownership of the NFT, ensuring that buyers can trace the token's origin.
Applications:
Digital Art: Artists are now tokenising their artwork as NFTs.
Collectibles: Virtual trading cards or digital pets (as examples).
Virtual Real Estate: Platforms such as Decentraland, Sandbox, and OpenSea allow users to buy, sell, and build upon parcels of virtual land, all tokenized as NFTs.
Gaming: In-game assets, such as skins, weapons, and characters.
🛠️ Utility Tokens
Utility tokens have a specific use and offer utility. They are created on the blockchain and are native to the platform they are used on. They are not to be considered as financial instruments, meaning that they are not securities, and are thus not subject to the same laws and regulations as securities or security tokens.
These tokens are typically issued during an ICO (Initial Coin Offering), IDO (Initial Dex Offering), or IEO (Initial Exchange Offering) where investors can purchase them in exchange for cryptocurrencies or fiat currencies. They are used to incentivise users to participate in a platform and to power the network. The use of a utility token is limited to the particular ecosystem that it is designed for.
🔐 Security Tokens
A security token, or a security, represents the partial ownership of an asset or a company. A security token represents rights of ownership, transfer of value, or promise of returns that are tokenised on a blockchain. It is intended to be treated as an investment instrument. As an investment asset, a security token is a digital asset that represents ownership or other rights. It transfers value from an asset or a bundle of assets to whoever holds the private keys to the token. Put simply, security tokens are the digital form of traditional securities.
Like regular securitised assets, there is an expectation of profit based upon the efforts of others. There also needs to be an "investment contract" between the issuer and the buyer.
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2. Understanding Blockchain Technology
Blockchain is how cryptocurrency (and other technologies) can operate.
2.1 What is Blockchain Technology?
Blockchain is the underlying technology that powers cryptocurrency. It is a distributed, decentralised ledger that records transactions across multiple computers in such a way that the recorded transactions cannot be altered retroactively. Each block in the chain contains a cryptographic hash of the previous block, a timestamp, and transaction data. This creates a secure and transparent record of transactions, making blockchain technology a game-changer in various industries.
2.2 How Does Blockchain Technology Work?
Blockchain is not too dissimilar from a spreadsheet or a database. A blockchain is similar because it is a database where information is inputted and stored. The main difference is that a blockchain structures and accesses data differently from a spreadsheet or a database.
A blockchain consists of scripts, which are programs that are tasked with conducting operations; entering and accessing information, and storing/saving it somewhere. A blockchain is distributed, which means multiple copies of it are saved across many different machines, and they all must match it for validity.
The blockchain collects transaction information and enters it into a block, similar to a cell in a spreadsheet that contains information. Once it is full, the information is run through an encryption algorithm, which creates a hexadecimal number called the hash.
From there, the hash is then entered into the following block header and encrypted with the other information inside the block. This creates a series of blocks that are chained together, hence the name blockchain.
2.3 Key Features of Blockchain Technology
Distribution: Decentralisation and Participation
Blockchain eliminates the need for a central authority by distributing the transaction data across a network of computers. The decentralisation not only enhances security but also removes the need for intermediaries, reducing transaction costs and increasing efficiency. The distribution of blockchain enables all participants to have access to the same information. Each node maintains a copy of the entire blockchain, ensuring redundancy and reducing the risk of a single point of failure.
Transparency and Security: Open and Auditable
Transactions recorded on a blockchain are transparent and immutable, meaning they cannot be altered or deleted. Every transaction recorded on the blockchain is visible to all participants through a publicly distributed ledger, creating a transparent ecosystem. This provides a high level of security and trust in the system, making blockchain technology attractive for various applications beyond cryptocurrency.
Immutability: The Foundation of Trust
Through the use of cryptographic hashing algorithms, each transaction or data entry within a blockchain is assigned a unique hash. This hash is then linked to the previous transaction and stored in a block, forming a chain of information that cannot be altered without deletion. The immutability of blockchain ensures the integrity and trustworthiness of the stored data. It serves as a digital record book that cannot be tampered with, providing a transparent and auditable history that eliminates the need for intermediaries.
Consensus: Reaching Agreement
Consensus mechanisms play a vital role in ensuring the accuracy and validity of transactions within a blockchain network. These mechanisms enable participants to agree on the order and validity of transactions, thus preventing double-spending and ensuring the integrity of the entire blockchain. Algorithms require participants to provide computational power or stake their cryptocurrency to secure the network and validate transactions. Through consensus mechanisms, blockchain achieves a high degree of security and trust, eliminating the need for centralised control.
Unanimity: Collective Decision-Making
Blockchain technology relies on the principle of unanimity, meaning that all nodes within a network must agree on the validity of a transaction or data entry. This consensus-driven decision-making process ensures that dishonest or malicious actors cannot alter the blockchain's integrity. Through unanimity, blockchain creates a secure environment where trust is built through the collective participation and agreement of all network participants. Each transaction is subjected to the scrutiny of the network, making it extremely difficult for fraudulent activities to occur unnoticed.
Settlement: Swift and Efficient Transactions
Unlike traditional payment systems that involve multiple intermediaries and lengthy settlement periods, blockchain allows for near-instantaneous settlement. By removing intermediaries and utilising smart contracts, blockchain eliminates the need for manual verification, reduces costs, and accelerates transaction speeds. This aspect of blockchain technology is particularly beneficial in industries such as finance, supply chain, and real estate, where time-sensitive transactions can be facilitated with ease.
2.4 Types of Blockchains
Public Blockchain: Transparency and Decentralisation
A public blockchain is a permissionless network where anyone can participate, view, and validate transactions. Bitcoin and Ethereum are examples of public blockchains. In a public blockchain, all transactions are transparent and can be accessed by anyone on the network.
Advantages:
✓ Completely independent of organisations; even if the organisation that created it ceased to exist, the public blockchain would still be able to run, providing there are computers still connected to the network.
✓ Transparency: As long as the users follow the security protocols and methods meticulously, public blockchains are mostly secure.
Disadvantages:
✖ The network can be slow, and companies cannot restrict access or use. If hackers gain 51% or more of the computer power of a public blockchain, they can alter it.
✖ Don't often scale well. The network can slow down as more nodes join.
Private Blockchain: Control and Privacy
A private blockchain is a permissioned network where only selected entities have the authority to participate in the network. This type of blockchain is often used by businesses and organisations that require more control over who can access and validate transactions. Private blockchains offer enhanced privacy and security features.
Advantages:
✓ Controlling organisation sets permission levels, security, authorisations, and accessibility. Prevents third parties from accessing certain information.
✓ Can be very fast and process transactions much more quickly than public blockchains.
Disadvantages:
✖ Goes against the core philosophy of blockchains; blockchains are supposed to be decentralised. Some people reuse to call them "true" blockchains.
✖ Users cannot independently audit or confirm the source code.
Consortium Blockchain: Collaboration and Consensus
A consortium blockchain is a hybrid between public and private blockchains. In a consortium blockchain, a group of organisations comes together to validate transactions and maintain the network. This type of blockchain offers shared control and allows participants to work together while retaining a certain level of privacy.
Advantages:
✓ Tends to be more secure, scalable, and efficient than a public blockchain.
✓ Similar to private and hybrid blockchains, it also offers access controls.
Disadvantages:
✖ Less transparent than a public blockchain.
✖ Can be compromised if a member node is breached; the blockchain's own regulations can impair the network's functionality.
Hybrid Blockchain: Versatility and Scalability
A hybrid blockchain combines the features of both public and private blockchains. It allows for the flexibility to choose between public and private modes based on the specific needs of the users. This type of blockchain offers versatility, scalability, and the ability to customise the level of transparency and control.
Advantages:
✓ Because it works within a closed ecosystem; outside hackers cannot mount a "51% attack" on the network.
✓ Transactions are cheap and fast and often scale better than a public blockchain.
Disadvantages:
✖ Is not completely transparent because information and be shielded.
✖ Upgrading can be challenging; there is no real incentive for users to participate in contributing to the network.
2.5 Types of Blockchain Consensus Mechanisms
A consensus mechanism is a self-regulatory stack of software protocols written into a blockchain's code that synchronizes a network into agreement about the state of a digital ledger. This is done by upkeeping a single data set, the mutually agreed-upon version of a blockchain’s transaction history, rather than employing each node, or in-network computer, to individually maintain its own copy of the database in its entirety. Although there are a variety of consensus mechanisms to consider when programming a network’s standard for verification, each approach is wired to discredit cheaters in their attempts to contradict the record.
Proof of Work (PoW)
Proof of Work was the first widely used blockchain consensus mechanism. It requires users to mine or complete complex computational puzzles before submitting new transactions to the network. This expenditure of time, computing power, and energy is intended to make the cost of fraud higher than the potential rewards of a dishonest action.
In a Proof of Work network such as Bitcoin, all the nodes on the network compete to be the first to solve the problem and 'prove their work,' and they get to add the latest batch of transactions to the blockchain and earn some bitcoin in exchange.
Proof of Stake (PoS)
Anyone with a small amount of Poof of Stake cryptocurrency can participate in staking. The rewards might be higher for those with bigger investments, but the roadblocks to getting started are lower than with major Proof of Work cryptocurrencies.
Staking is a bit like voting, although, with most Proof of Stake cryptocurrencies, the process doesn't involve "one person one vote." Instead, participants, known as validators, stake a certain amount of crypto behind the block they want to be added to the chain, with different blockchains setting different limits for this amount.
Delegated Proof of Stake (DPos)
Delegated Proof of Stake is a blockchain consensus mechanism where network users vote and elect delegates to validate the next block. Like a traditional Proof of Stake mechanism, DPoS uses a collateral staking system. However, it also uses a specific democratic process designed to address PoS's limitations. This allows it to offer a more affordable, efficient, and fair way to validate transactions.
The Delegated Proof of Stake consensus mechanism works using a democratic process. The network users vote to delegate the block validation rights to delegates, also called witnesses or block producers. Voters maintain control over the system. Users can also vote out delegates if they make malicious attempts on the network. As such, delegates with a strong reputation are usually elected as witnesses.
Zero-Knowledge Proof (ZKP)
ZKPs are cryptographic methods used to prove users know the wallet's private keys without revealing the information itself when proving it. That is, the information will prove the knowledge while protecting the data’s privacy. In the case of executing smart contracts, this means that a prover must demonstrate critical knowledge, and a verifier must confirm the validity in a reasonable amount of time.
Fundamentally, ZKPs involve verifiers asking provers to perform specific tasks which could only be performed if the prover knows the wallet's private keys. If the verifier's test is robust, and an honest prover can easily perform the required tasks, then the test can verify the prover's authenticity in such a way that only an honest prover could pass the verification process successfully.
Other Types of Consensus Mechanisms
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